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Chapter 18
Economics of
Retirement and
Healthcare
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
• Apply the life cycle theory of retirement and
identify the main sources of retirement funds.
• Explain the difference between defined
benefit and defined contribution retirement
plans.
• Summarize the demographic challenge facing
Social Security and describe the possible
solutions.
• Describe the healthcare life cycle, its
problems, and the role of health insurance.
• Discuss reasons why healthcare spending is
rising so quickly.
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Basics of Retirement
• Retirement means that someone no longer
has income from work and must finance
their level of spending.
• The life-cycle theory of retirement says
people spend when they are young, save
during the latter part of their working lives,
and then spend while they are retired.
– That is, they build up a nest egg and then spend
it down.
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Basic Financial Life Cycle
Youth:
Spend on education
and buying a home
Net
worth
Middle Age:
Build up savings
Peak earning
years
Borrowing for
home and
education
Old Age:
Use savings for
medical and
living costs
Retirement
Age
18-4
Where Adults over 65 Get
Their Money, 2009
Earnings from Work
Social Security
Percentage of average
income for people 65
and over
26%
41%
Public and Private Defined
Benefit Pensions
18%
Defined Contribution Plans
and Individual Retirement
Accounts
1%
Income from assets
11%
3%
All Other
18-5
Problems with the Life-Cycle
Theory
• Two things can go wrong with the lifecycle theory:
– The retirement poverty problem occurs
because poor people often cannot save
much for retirement.
– The retirement uncertainty problem
occurs because individuals don’t know
how long they will live.
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Employer Retirement Plans
• Employer retirement plans are
provisions for retirement that your
employer contributes to on your behalf.
• There are two types of employer
retirement plans:
– First, a defined benefit plan provides
retirees a pre-determined amount of
money monthly.
• This plan is funded by the employer.
18-7
Employer Retirement Plans
– Defined contribution plans require
employees to put money into an account,
which the employer then invests.
• The payments from a defined contribution plan
depend on how well investments have
performed.
• As a result, the retirement benefits are not
guaranteed
• The most important form of defined contribution
plan today is the 401(k) plan.
• In recent years, there has been a move away
from defined benefit plans toward defined
contribution plans.
18-8
Social Security
• The Social Security Act was passed
in 1935 to solve the retirement poverty
problem.
• Social Security places a tax (FICA) on
current workers to pay the retirement
benefits of current retirees.
– There is an implicit commitment that
future workers will do the same and fund
the retirement benefits for today’s
workers.
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The Life Cycle with
Social Security
In principle, Social Security can solve
both the retirement poverty problem
and the retirement uncertainty
problem.
18-10
How Social Security Works
Today
• Social Security is the best source of
income for people 65 and over.
• There is a a formula for determining
your monthly benefits.
– That formula depends on the average of
your lifetime earnings, adjusted for the
rise in average wages over time.
– The formula is progressive, so that lowincome workers get back a higher
percentage of their lifetime average
income than better-paid workers.
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How Social Security Works
Today
• There is also a formula to determine
how much payroll taxes the employee
and employer pay.
– Taxes are paid into the Social Security
trust fund and invested in Treasury bonds.
• There is no link between the taxes you
pay and the benefits you receive later in
life.
– Congress can change the benefit formula
and the tax rate at its discretion.
18-12
Demographic Challenge
• The principles underlying Social
Security work well if the population and
real wages are expanding.
• But funding becomes more difficult if
population growth slows.
• The old-age dependency ratio is the
ratio of the older population to the
working age population.
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Demographic Challenge of
Social Security
18-14
Will Social Security Run
out of Money?
• Currently, the Social Security program is
running a surplus.
• The surplus is invested in government
bonds, so, in effect, the Social Security
trust fund is lending money to the rest of
government.
• The problem is in the future when
payments for Social Security benefits will
exceed the revenues received from the
payroll tax.
18-15
Fixing the Retirement Shortfall
• Four possible solutions to the Social
Security financing gap:
– The first possible solution is a cut in
benefits.
• This need not be an across-the-board cut.
• This can be accomplished through a higher
retirement age or a reduction in benefits for
high-income households.
– A second solution is to raise the payroll
tax, either by increasing the rate or lifting
the cap.
18-16
Fixing the Retirement Shortfall
– A third possible solution is to fund the Social
Security funding gap by using general tax
revenues from income and corporate taxes.
– The final possible solution is privatization,
which would be a major change in the Social
Security system.
• This involves moving more of the decisions and
responsibility of retirement saving into the private
sector, while preserving a basic safety net for the
poor and unlucky.
• The problem of privatization is the return of the
retirement uncertainty problem.
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Why Don’t Americans Save?
The Personal Savings Rate
18-18
Basics of Healthcare Spending
• Healthcare is the largest sector of the
economy, accounting for 17.6% of GDP in
2009. That is nearly double the amount
spent as a percentage of GDP in 1990.
• Most significant is the fact that healthcare
spending has been growing at a rapid rate.
• A major challenge for policymakers is to slow
down the rate of increase while maintaining
care for everyone.
18-19
Per Capita Healthcare Spending
Across the World, 2008
18-20
Life Cycle Theory of
Healthcare
• In healthcare, the market consumption
decision is not voluntary, but forced by an
external event such as becoming sick.
• There are three type of health events:
– First, there’s the flow of ordinary healthcare
expenses when you are young and middle-aged.
– Second, there’s the relatively rare catastrophic
health event in youth and middle-age.
– Finally, there’s the inevitability of a steady stream
of old-age-related health expenses as you age.
18-21
Healthcare Life Cycle Theory
The life cycle theory has three problems:
• The poor can’t afford to pay for the insurance (the
healthcare poverty problem).
• It is difficult to predict how much money is needed for
healthcare when retired (the healthcare uncertainty
problem).
• The problem of adverse selection, where healthy people
do not buy insurance.
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Healthcare Funding
• Healthcare is funded by three sources:
– The first is spending by individuals on their
own.
– Second are employer health insurance plans,
where companies set up a health insurance
plan for their employees.
– Finally, the two government-funded
healthcare programs.
• Medicare covers the healthcare costs of older
citizens, and Medicaid covers low-income
families and children, their caretaker relatives,
and individuals with disabilities.
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Who Doesn’t Have Health
Insurance: 2009
18-24
Rising Cost of Healthcare
• There are six reasons why healthcare
costs are rising at a rapid rate:
– Demographic changes are the first reason.
• The population over 65 is increasing, and they
tend to consume more healthcare than young
people.
– Second, healthcare is a luxury good, so as
incomes rise, consumption on healthcare
increases.
• As people become richer, they spend more on
healthcare.
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Rising Cost of Healthcare
– A third reason is that most healthcare
payments are made by a third party and
not the patient.
• These payers are either a health insurance
plan, Medicare, or Medicaid.
• With a third party, the normal sorts of
constraints on purchases are not present.
• Doctors can order expensive tests and
treatments without worrying about the cost,
and the patients can agree without worrying
about having to pay.
18-26
Rising Cost of Healthcare
– The fourth reason is the tax deductions
for employer healthcare.
• Workers receive compensation, in the form of
healthcare, which is not taxed.
– Another reason is that the rapid pace of
technological change has resulted in
the development of very expensive new
procedures.
– Finally, the practice of bad medicine,
where some healthcare practices do not
work.
18-27
Policy Response
• There is a great debate about what
role the government should play in
addressing the healthcare problem.
• Some economists argue that the US
should move toward a single-payer
system.
– Under this system, the government
handles healthcare, and everyone is
automatically covered.
– Such a system has several advantages: it
eliminates the poverty problem, the
uncertainty problem, and the adverse
selection problem.
18-28
Policy Response
– It also potentially reduces the administrative
costs of running the healthcare system.
– However, it’s not clear that a move to a
single-payer system would slow the growth
rate of healthcare costs.
• At the other end of the spectrum, some
economists support the idea of increasing
individual responsibility for healthcare
spending.
– This gives patients an incentive to monitor
their own spending.
18-29